The Real Problem was Refinancing

Three trends in the U.S. housing market combined to dramatically magnify the losses of homeowners between 2006 and 2008 and to increase the systemic risk in the financial system. Individually, these trends – rising home prices, falling mortgage rates, and more efficient refinancing – were neutral or positive for the economy. But together, they lured masses of homeowners to refinance their homes and extract equity at the same time (“cash-out” refinancing), increasing the risk in the financial system, according to Amir Khandani, Andrew Lo, and Robert Merton. Like a ratchet tool that could only adjust in one direction as home prices were rising, the system was unforgiving when prices fell. In Systemic Risk and the Refinancing Ratchet Effect (NBER Working Paper No. 15362), these researchers estimate that this refinancing ratchet effect could have generated potential losses of $1.5 trillion for mortgage lenders from June 2006 to December 2008 – more than five times the potential losses had homeowners avoided all those cash-out refinancing deals.

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Using a model of the mortgage market, this study finds that had there been no cash-out refinancing, the total value of mortgages outstanding by December 2008 would have reached $4,105 billion on real estate worth $10,154 billion for an aggregate loan-to-value ratio of about 40 percent. With cash-out refinancing, loans ballooned to $12,018 billion on property worth $16,570 for a loan-to-value ratio of 72 percent.

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This ratchet effect can create a dangerous feedback loop of higher-than-normal foreclosures, forced sales, and, ultimately, a market crash. With home values falling from the peak of the market in June 2006, the study’s simulation suggests that some 18 percent of homes were in negative-equity territory by December 2008. Without cash-out refinancing, that figure would have been only 3 percent.

Does this matter? I am not so foolish as to try to make moral judgments about millions of people I have never met, so you won’t catch me saying; “Aha, they weren’t taking out these mortgages to put a roof over their children’s heads, but rather to get cash to buy a big screen TV and a boat.” For all I know the cash-outs were to meet unforeseen medical expenses.

But here is how it might matter. Earlier I mentioned that in a world where first best policies are politically impossible (i.e. eliminating FDIC, TBTF, Fannie and Freddie, tax deductibility of mortgage interest) then maybe we should consider second best policies such as a requirement that people put at least 20% down on mortgages. At the same time I recognized that even that sort of regulation would be impossible to get through Congress. It is true that countries such as Canada and Denmark make it tough to get sub-prime mortgages, but their political systems are probably much less corrupt than ours. Perhaps if we formed 50 separate countries, as I advocated earlier, we might get sensible reforms in states (like Minnesota?) with cultures similar to Canada and Denmark.

But this NBER study suggests there might be a slightly more politically palatable alternative, which could be almost as effective. What about simply requiring at least 20% down on all refinancing, but continue to allow sub-prime loans on home purchases?

I suppose people would try to evade these regulations by moving next door. Of course that sort of subterfuge is very costly, a factor that cuts both ways when considering the pros and cons of this sort of regulation. Or how about exempting only first time home buyers from the 20% down. Would that be more politically feasible? Would it be too costly to enforce?

My first choice is still for second best policies that require everyone put at least 20% down on all mortgage loans, as this sort of regulation would also address another government failure, the enormous disincentives to save built into our fiscal policies.

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.